Private Equity: Threat or Menace?

David Lonsdale built and sold three venture-funded companies before becoming president and co-owner of Allegiance Capital in 2005, which provides M&A financial services to middle market business owners.

You may have noticed that there’s an election this year. Given the tone of Washington politics this year, it's not surprising that the election ads have turned a bit nasty. What is surprising, though, is that the target of one of the attack ads is private equity.

As a campaign hot button, you wouldn't think that private equity is on a par with war, or Social Security, or health care. But because Mitt Romney is touting his experience at private equity group Bain Capital, the Obama campaign is doing its best to paint private equity – and, by extension, Romney – as greedy, unscrupulous, and indifferent to the middle class. Their latest ad calls Romney a "vampire" and “job destroyer,” describing a particular transaction where Bain bought a flagging company, GST Steel, which later went bankrupt and put 750 employees out of work.

That sure sounds bad. But as an M&A professional who advises entrepreneurs on their exit strategies and funding alternatives, I’m more than a little concerned that the entire private equity industry will end up tarred and feathered by Presidential politicking. The fact is, a private equity transaction can be a very positive thing in your life and that of your established business, and if you refuse to consider a deal with a private equity group because a political ad maintained that the industry is made up of vampires and frauds, you’re out of your mind.

Let’s start at the beginning.

So, What is Private Equity, Exactly?

Private equity is simply a catch-all term for groups that invest in mid-sized companies not publicly traded on the stock market. A private equity group raises money, often hundreds of millions of dollars, from institutional investors like pension funds, banks, and mutual funds. There are over 3,000 private equity groups in North America, and right now, they collectively have more than $400 billion to invest. Unlike mutual funds, say, which are prohibited from buying more than a sliver of any company’s public stock, private equity funds aim to take a controlling interest in the companies they invest in.

They're generally not interested in start-ups (for that you'd generally want an angel investor), or in small tech companies with more promise than revenues (venture capital territory). Instead, they generally aim for a company that has some scale and has been operating for a while and is ready to make a transition: say, to enter a new growth phase, to pass from the founder to a team of managers, or to reverse a slide in fortunes.

What’s in It For You?

A private equity group might buy your company for tens of millions of dollars (or more) and give you the chance to start a new company or start to enjoy life as a rich person. Any questions?

Do You Have to Give Up Control of Your Company?

Some private equity groups take a hands-on approach, bringing in new managers, who presumably can return the company more effectively. Other P.E. firms prefer not to be involved in day-to-day operations, and focus on companies where the management wants to stay on, or where there is an up-and-coming team ready to grow the company to the next level.

What Does a Private Equity Group Want from You?

ROI. Pure and simple.

Like any other money manager, a private equity group just wants a good return on their clients' investment. They are not in the business of intentionally running portfolio companies into the ground—or, for that matter, in preserving jobs for the sake of charity. Their purpose is to make sure their clients end up with more money than they started with.

What Might You Want from Private Equity?

Growth capital. Your line of high-tech camping gear has been researched, developed, patented and produced. . . and you can’t make enough to meet customer demand. Good problem to have, right? A private equity partner can step in with the capital you need to scale up without going into debt.

Strategy and talent. You now have a nice share of the high-tech camping gear market, and you want an experienced Board of Directors to provide strategic support. Private equity groups often have access to a large talent pool and can provide you with strong assistance.

An exit. You built this company with your blood, sweat and tears. . . and you’re so busy, you never get to use any of your products. It’s time to enjoy the fruits of your labor. You can sell to a private equity firm, walk away with a few million in cash, and spend the next year hiking the Rocky Mountain Trail.

Take, for example, investment by private equity groups KKR, Silver Lake, and Technology Crossover Ventures in GoDaddy, the $1.14 billiion (revenues) internet hosting service. The trio paid nearly $2.25 billion for a majority stake last summer and are now focused on expanding internationally, selling additional services such as data storage, and elevating the company’s bawdy image. Oh, and in the process they made founder Bob Parsons insanely wealthy and made millionaires of 35 of his employees.

And those Ads About Vampires, GST Steel, and Layoffs...?

Just politics as usual. Some private equity groups have stooped to practices like piling up debt on portfolio companies in order to pay themselves dividends and leave succeeding management teams (or creditors) holding the bag. You may be shocked to learn that not all 3,000 private equity firms are made up of saints or management geniuses. But this is America. If you don't trust a private equity group, you can sell to a different one, or to no one at all. But to rule private equity out entirely makes no sense at alll.